Switzerland’s recovery has been broadly balanced despite strong appreciation of the Swiss franc. Capital markets’ concerns regarding sovereign debt in several countries have led the Swiss franc to appreciate to record levels. While deteriorating price competitiveness was partially compensated by strong global demand for Swiss goods and services, exports have recently begun to weaken. The SNB has introduced an upper limit on the euro/Swiss franc exchange rate to stop appreciation. While keeping interest rates low for some time is appropriate, unusually low interest rates have boosted mortgage lending and house prices. To avoid building up imbalances, additional macroprudential tools should be introduced.

Switzerland emerged relatively early from a recession that had been less deep than in the euro area. The recovery continued in the first half of 2011, although with slowing momentum (Figure 1). Domestic demand has been boosted by investment, notably in construction. Financial services output has recovered, although at a slower pace than in previous expansions. Substantial employment growth has continued to lower unemployment while absorbing a large inflow of foreign workers (Figure 2, Panel A). While the output gap is now small, consumer price inflation remains low, as exchange rate appreciation damped import prices, notably for imported commodities and oil.

The tax burden in Switzerland is low in international comparison, largely reflecting the substantial non-tax compulsory contributions towards the health and pension systems which are managed by private institutions. Taxation of personal income and labour earnings is relatively high, whereas the taxation of consumption is low. Empirical research on OECD economies and on Switzerland specifically indicates that shifting taxation away from personal income towards the taxation of consumption would strengthen incentives to engage in economic activity. The structure of the corporate tax burden could be improved to remove disincentives for small firms to grow. Reducing the generous provisions which allow interest payments to be deducted from taxable personal income would reduce incentives for households to excessively leverage their wealth, with benefits both for financial stability and equity in the tax system. While tax competition among sub-national authorities has reinforced fiscal discipline, adverse side effects on equity could be reduced, including through greater reliance on real estate taxation in municipalities.

Despite some deleveraging over the past 3 years, the very large size of the balance sheets of the two big banks represents a major potential risk for the economy and public finances. These risks are reinforced by the low level of loss-absorbing capital held by them. Legislation, approved by parliament in September 2011, will reduce these risks, notably by strengthening capital requirements, although the foreseen leverage ratio of about 5% implies only a modest capacity to absorb losses. A stricter leverage requirement would generate substantial benefits and little cost to the economy. Contingent convertible bonds can contribute about half to required capital, so it is crucial that they are designed to ensure that they provide effective cushions in a systemic crisis. The planned reform also requires banks to develop mechanisms for their own resolution in case of failure but credible mechanisms of this kind have yet to be developed and require international co-ordination. Bank regulation needs to consider system-wide risks more explicitly. Macro-prudential regulation would also help the authorities to prevent excessive mortgage lending growth in the context of exceptionally low interest rates. Cantonal banks have expanded mortgage lending particularly actively. Removing the explicit government guarantees for their liabilities would also help lower risks. A partially-funded deposit insurance scheme would provide further stability to the Swiss financial system. Significant improvements in the regulation of pension funds have been introduced, although further steps are desirable.

Switzerland has low greenhouse gas emissions per capita as compared to other countries, which reflects the strong reliance on energy sources emitting few greenhouse gas emissions, especially in electricity generation, and little heavy industry. Greenhouse gas emissions have remained almost the same since 1990, as emission reductions in the residential and industrial sector were offset by increases from the transport sector. It is estimated that, in aggregate, marginal abatement costs are relatively high in Switzerland and meeting the 2020 target of a 20% emission reduction below the 1990 level will necessitate more cost effective policies. In particular, more needs to be done in the road transport sector, the domestic sector with the largest potential for emission reductions at relatively low cost. The incentive for energy-saving renovations in rented dwellings could be raised by a better design of existing policies. And the policies in the industrial sector could be made more effective with the transition towards linking the Swiss and the EU emission trading systems.